The danger of Chinese overproduction

By colyapi on January 8, 2013 • ( 4 )

Overproduction Takes Shine Off Chinese Pearls

Coal, iron ore, steel, cotton, clothing, heavy equipment, ship-building, solar cells, LEDs, and property. All of these commodities at one point or another in the last year have been a hot topic due to overstocks caused by government-influenced overproduction. Falling prices and decreased global demand have crippled many participants in these industries, and many bankruptcies and collapses have occurred. And they are emblematic of the problems that China is going to continue to face in the future.

China’s economic growth has been based significantly on a rapid expansion of government stimulus through monetary expansion over the past several years. And this policy has borne fruit. GDP is up, and growth rates, although not always meeting expectations, regularly exceed the growth rates being achieved in the rest of the world. But this growth comes with a price – an instability in the very markets it seeks to develop and grow.

Monetary stimulus injects liquidity in to the markets in an effort to circumvent the natural processes and operation of the markets. Normally, the interest rates indicate to consumers and producers the level of saving being undertaken by the public, and the amount of resources that are being set aside which can be borrowed to promote capital growth in longer term industries. When consumers are interested in near-term satisfactions, their time-preferences are high, and a high interest rate is required to induce them to lend.

When consumers’ preferences are for the greater amount of satisfactions that can be obtained by holding back on consumption and waiting for longer-term projects to be finished, their time-preferences are low, and they are more willing to put their money into loanable savings which lowers the rate of interest. The interest rates, therefore, help to coordinate consumer desires with production plans through investment activity.

By artificially lowering the interest rates, false signals are sent to producers that consumers are interested in more investment activity than they actually are. Businesses begin, therefore, to take on projects that they otherwise wouldn’t, because the restricted available funds would restrict the number of entrants into a particular field.

But now, too many funds are available, and all sorts of business activity is begun. This looks great on paper, as all sorts of development, construction, and hiring are initiated, which leads to all sorts of development, construction, and hiring in the subsidiary industries which feed these projects. But the problem is that too much has been begun. More so, in fact, than the public actually has an interest in.

When the time comes for these new products to hit the economy, there isn’t sufficient demand for them all. A situation of oversupply begins to develop. In order to correct this, the market insists on a fall in prices in order to match the actual demand with the existing supply. But many of the projects that were started depended on a “stability” of pricing that would engender them with a certain level of expected profits. The fall in prices, therefore, cuts profits, and makes many marginal firms untenable. A spiral begins to develop as firms rush to correct their business plans to meet the new reality, and economic trouble ensues.

This is the situation that China finds itself in today. Government stimulus has been great for boosting production rates and GDP growth across the country. All sorts of ore and steel and agricultural products have been produced by the massive expansion of productive capacity of the Chinese economy. But this monetary stimulus has only managed to result in the Chinese economy overproducing in all sorts of sectors, and has not managed to create sufficient demand for these projects to keep the market cleared.

Normally, the markets would penalize overproduction through losses, and production would only be expanded to fit the projected actual needs of the public. But these restrictions have been circumvented by the rules and regulations businesses in China have to face. Instead of cutting back on production in the stimulated fields, incentives are given to the industries they feed, the buyers of those products, to expand their own production in order to clear the increased supply. But this only succeeds in pushing the day of reckoning further into the future.

It does not succeed in correcting the initial economic instability, which continues unabated, and, in fact, continues to expand under the previous incentives. Moreover, it succeeds in creating a second instability, in that the newly stimulated production areas eventually face their own problem of overdevelopment.

Overproduction of iron ore leads to stimulation of and overproduction of the steel industries, which lead to stimulation of and overproduction of ships, heavy equipment, and buildings. Overstimulation of cotton leads to stimulation of and overproduction of textiles which leads to stimulation of and overproduction of clothing. Overstimulation of photo cells and solar cells leads to overstimulation of and overproduction of the solar industry. Eventually all sectors of the economy are promoted beyond the ability of the public to consume.

All this stimulation by government leads to a wild euphoria of participants in these industries. People feel liberated with the new incomes they have and the fresh money in their pockets. This leads to wild spending habits and speculation in all sorts of areas. Lately, it has been reported that speculative bubbles in wine, apples, property, and even graves have grown up all over China. Some cities, such as Changsha, are even reporting how people are “releasing their spending power” by borrowing against paychecks in order to keep up their newfound lifestyle. Many of these bubbles have already burst, such as in the mining town of Ordos, while others are showing the early stages of a collapse.

Chinese efforts to contain the oversupply through government buying programs are only going to make things worse. Many such efforts were attempted in the United States during the Great Depression, only to be rejected as failures. Government buying programs only succeed in transferring ownership of the supply to the government without curbing, and even sometimes encouraging, through creation of a guaranteed buyer, the habits of the producers.

Eventually this stock must be liquidated, either by direct destruction and loss by the government, or by dumping programs, which will only succeed in bringing about price swings on the markets as prices are initially depressed from the dumping before rising back to the rate at which the Chinese government continues to buy. All of these policies end up destroying wealth by simultaneously attempting to encourage and discourage production.

Clearly, the Chinese government has a serious problem on its hand of what to do with the monster they have created. To let the markets correct is to allow a liquidation and correction to occur, revealing the error of their ways. But to let the process continue is to run a race against reality, with the magnitude of the problem, the size of the economic instabilities, growing greater every day.